Top tips for considering ESG risks and opportunities in the employer covenant process

A scheme’s investment and funding decisions should reflect the ability of the sponsoring employer to support it financially both now and in the future. Assessing the strength of the employer’s covenant should therefore be part of an integrated approach to risk management for defined benefit (DB) occupational pension schemes. The covenant process requires trustees to consider the sponsor’s ability to address a range of likely future scenarios. These include the impact of climate change, biodiversity threats, inequality and other challenges. ESG-related risks may impact:

• The sponsor’s financial capacity to support the scheme, due either to the magnitude of ESG-related risks or the capacity of the sponsor to absorb that risk on an ongoing basis.
• The strength of the sponsor’s covenant over time and in particular, for the time horizon over which a sponsor might be needed to support the scheme.

A4S and the Employer Covenant Practitioners Association (ECPA) have produced a guide for trustees and their advisers on the ‘why’ and ‘how’ to embed ESG-related considerations into the employer covenant process.

While the employer covenant evaluation process is unique to the UK pension market, the ‘top tips’ within this guide are also applicable to global asset owners who need to undertake due diligence and consider a sponsor’s future resilience.